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The danger of derivatives is compounded by the fact that this fantastic % system of side bets is not based on old-fashioned human hunches but on calculations designed and monitored by computer wizards using abstruse mathematical formulas that even their bosses at major trading houses do not really understand. "None of us really knows what the implications are, because nothing like this has ever happened before," concedes financial- market analyst Lowell Bryan, a partner in the consulting firm McKinsey & Co. Concurs a senior partner in a financial firm that is heavily invested in the derivatives market: "Whenever we get a new product and it's working and hasn't been tested, Wall Street won't ever try it for just $5 billion or $10 billion. It's got to go for $20 billion, $50 billion or $100 billion without knowing what will happen under certain market circumstances. They have the numbers, but they don't have either the judgment or the experience to understand them."
This latticework of contracts may seem isolated in a kind of financial cyberspace, but it produces real victims. In Japan the accounting director of Nippon Steel Chemical leaped to his death beneath a train last May after he lost $128 million of the company's money by using derivatives to play the foreign-exchange market. In Chile a derivatives trader named Juan Pablo Davila lost $207 million of taxpayers' money last fall, instantly earning himself a place in Chilean infamy, by speculating in copper futures for the state-owned mining company. In Germany the giant conglomerate Metallgesellschaft dwarfed even those losses when it dropped $1.3 billion last year by betting the wrong way on oil-futures contracts. Only a last-minute bailout by the company's banks saved it from bankruptcy.
Derivatives have clearly heightened the anxiety in stock, bond and currency markets around the world in the weeks since the U.S. Federal Reserve began raising interest rates for the first time in five years. The Fed's move on Feb. 4 led the aggressive speculators who run high-rolling investment vehicles called hedge funds, which use derivatives in daily trading, to dump billions of dollars' worth of bond futures and thereby drive down the prices of the underlying bonds. The worst fallout occurred in Europe, where bond prices plunged and interest rates, which move in the opposite direction of prices, climbed about one full percentage point. The biggest loser amid the global turmoil was legendary Wall Street investor Michael Steinhardt, who as of last week has lost $1 billion since the beginning of the year, or a quarter of the funds under his management. Another big-name investor, George Soros, got caught in the February mayhem, which people inside his Quantum hedge fund called the "St. Valentine's Day Massacre." Soros lost $600 million on Feb. 14 by wrongly betting that the U.S. dollar would rise against the yen. (Don't cry for Soros, though. He reportedly earned $650 million in 1992 and at least as much last year, eclipsing Michael Milken's 1987 record of $550 million.)